Is it the right time to buy real estate stocks?

MUMBAI: After underperforming in 2013, when it declined almost 34 per cent, the BSE Realty Index has rallied by 21 per cent over the past month. For a long time now, retail investors have shunned real estate stocks.

The run-up in real estate prices in the major metros and rising interest rates have affected the demand for housing. Demand for office space also remains weak in a slowing economic environment, while the retail segment continues to bear the brunt of overcapacity and decline in consumer spending.

The industry's notoriously opaque and customer-unfriendly practices and massive debts had also in the past turned investors off. The current rally, however, underlines the need to evaluate realty stocks with a fresh eye.

What's driving the rally?

The foremost factor behind the current rally in real estate stocks is sentiment. With an NDA-led government expected to assume office after the elections, investors have been more willing to bet on domestic cyclical stocks (vis-a-vis outsourcing and defensive stocks).

Real estate stocks have also benefited from the increased appetite for cyclicals. A few sector-specific factors have also played a part in driving this rally. According to Bhaskar Chakraborty, real estate analystinstitutional, India InfolineBSE 0.00 %, prices have corrected by about 20 per cent from their peak levels in the National Capital Region (NCR).

In Mumbai they have corrected by about 8-10 per cent in the second half of 2013-14. With consumer price inflation showing a downward bias and the currency also stabilising (which helps reduce inflation), there is a high probability that interest rate cuts could begin over the next 6-9 months.

The benchmark rate could decline by 50-100 basis points in the next 18 months, which would in turn lead to lowering of home loan rates. The combination of these two factors—price correction and the possibility of a decline in interest rates—could make housing more affordable and bring about a revival in demand.
Realty stocks, according to Realty stocks have surged by more than 20 per cent in the past month, though the sector's fundamentals have not improved much. Find out if you should buy these now. Is it time to buy real estate stocks? Chakraborty, are rallying in anticipation of these developments.

A couple of other developments have also taken place that will have a salutary impact on investor perception about the sector. Aashiesh Agarwaal, VP-Research, Edelweiss Financial ServicesBSE 1.66 %, informs that the approval scenario has improved both in Mumbai and Bangalore, and private equity firms have in recent times displayed greater appetite for investing in real estate projects.
The expectation that the economy could rebound in the second half of 2014-15, always a positive for the sector, has also contributed to improved sentiment.

And finally, valuations had corrected quite sharply in the first half of 2013-14, and are currently bouncing back from those low levels. Says Agarwaal: "With many of the concerns about the sector abating, it has performed well recently."

Ground realities largely unchanged

While investor sentiment may have perked up in anticipation of a turnaround in the real estate sector, the situation on the ground remains grim.

According to Anuj Puri, chairman and country head, JLL India, "There has been little change in transaction volumes or the leasing scenario. The Indian real estate market is currently holding its breath until the elections get over, a new government is formed, and its business-related policies are announced."

Residential segment: While Mumbai and the National Capital Region (NCR) continue to be in the grip of the ongoing slowdown, Bangalore has fared better. Transaction volumes have been low in the Mumbai Metropolitan Region, the only exceptions being the new projects launched at lower prices, and areas like the extended suburbs and Navi Mumbai.

Developers have been amenable to price negotiations of 7-12 per cent to push sales. The NCR's housing market remains subdued. Sales, according to Puri, have sustained at a satisfactory level only in areas where there is visible momentum in infrastructure development.

Bangalore has fared better because of the return of vibrancy to the IT-ITES sector. There has been some softening in volumes in the past two quarters with price sensitivity setting in. The luxury segment has slowed down visibly.

Office segment: Demand for office space remains subdued and is nowhere close to the peak levels seen in 2007-8, when it stood at 40 million square feet. In 2012-13, it is expected to be about 25-26 million square feet.

In the NCR and in Mumbai, where inventory levels are high, the growth in rental rates has been slow while in Bangalore and Pune rental rates have moved up because inventory levels have been declining.

Retail: Absorption of space in malls continued to be weak throughout 2013 after the poor levels observed in 2012 across India's top seven cities. A key impediment to improvement in demand is the issue of allowing FDI into retail.

With the Bharatiya Janata Party (BJP) threatening to ban FDI in multibrand retail if it comes to power, foreign investors have put their decisions on hold until the next government's policies become clear.

With new retail players not coming in, the demand for space has been affected. The segment suffers from over-capacity with a lot of capital remaining locked up.

Only players who have put up the right product at the right location are finding tenants and renewing leases at higher levels. The decline in consumer spending has also affected the segment adversely.

A few positives

Notwithstanding the current slowdown, the sector still has a few things going for it. The first, of course, is the high potential demand for housing. A technical committee of the Ministry of Housing and Urban Poverty Alleviation estimated the housing shortage in India at 18.7 8 million in 2012.

The growing middle class and increasing nuclearisation of families is expected to fuel the demand for housing further. Meanwhile, hit hard by the slowdown, developers have realised that it can't be business as usual. They are now trying to get their act together.

Says Agarwaal: "Developers have become more focused on execution and project delivery. They have also realised that they cannot allow debt to burgeon to unsustainable levels." While debt remains a concern for the sector, some players are trying to address this issue. Foremost among them is DLF, which has brought down its debt by Rs 6,000 crore over the past one year.

Oberoi has zero debt, while Sobha and Prestige have managed to rein it in to low levels. Chakraborty of India Infoline points to signs of a possible turnaround in the sector.

"Volumes have bottomed out, prices are coming down and interest rates may also decline in due course. This will lead to improved affordability after which volumes are likely to recover. Moreover, valuations are quite favourable within the sector." In his view, investors should bet on this sector in anticipation of a recovery in volumes.

Key negatives

First, transaction volumes remain low and need to gather pace in key markets like Mumbai and the NCR. The lack of job generation in urban areas and the consequent weak sentiment has hobbled the sector (see box: Realty consumer sentiment subdued).

According to experts, only when a sustained economic recovery takes root will volumes revive. In Mumbai, especially, but also in several other metros, affordability too remains a big hurdle for buyers after last decade's price rise.

What should you do?

When investing in real estate stocks, one important point to remember is that this sector is very heterogeneous in nature. Currently, while developers from Mumbai and the NCR are struggling, those focused on cities like Bangalore and Chennai are faring better.

Avoid players who are still saddled with high debt. Those with a dodgy track record on the corporate governance front should also be shunned. Next, we discuss four stocks from the real estate sector whose track records are good or average, but whose prospects appear bright.

Oberoi Realty: Oberoi Realty is present in a market, Mumbai, where product differentiation, brand and location matter a lot to buyers. Oberoi leads on all these three parameters.

Its balance sheet strength too has eroded over the past three quarters, but it is still better off than most real estate company. It is the only player within the sector that has zero debt and is cash rich. Its land banks are attractively located.

"Whenever demand revives, Oberoi will be well placed to capture it," says an analyst at Emkay Global Financial Service. Oberoi also has good income flows coming from rentals to support its fixed costs.

Prestige Estate: Bangalore, Chennai and a few other southern cities are expected to see an increase in absorption of commercial space this year. This is in contrast to Mumbai and Delhi, where demand for commercial space remains weak.

Absorption could be 15 per cent higher in these cities in 2014 compared to 2013. Prestige is one real estate company in the southern markets in the listed space that has a strong portfolio of commercial projects.

It is well placed to capture a high share of the increase in demand for commercial space. Its rental income growth is also expected to be strong. Prestige also has a good pipeline of projects lined up for the next couple of years, so revenue growth is expected to be healthy.

Collections from previous sales will also help generate high cash flows. The only marginal worry is that the company's debt has been increasing since it has been pumping in a lot of capital into commercial real estate projects. Nonetheless, you may bet on this company as it enjoys growth visibility.

Sobha Developers: This South-based developer is almost exclusively a residential developer and manages its working capital well. It has strong cash flows and its balance sheet remains clean.

As interest rates come down, it is likely to see an improvement in volumes. In the fourth quarter of 2013-14, Sobha launched four projects, which the management believes will boost its sales in 2014-15.

In view of the growing price sensitivity of the Bangalore market, the company has launched two projects of lower ticket size. The company sees its minimum ticket size at Rs 60-70 lakh.

In the future, the company aims to enhance its presence in the NCR market, which it believes has the maximum growth potential. It plans to launch more projects in Pune as well. The company plans to deliver 7.5 million square feet annually by 2016-17.

Brigade Enterprises: The company is focused on the Bengaluru residential market and plans to launch 10 million square feet worth of projects over the next 12-to 15 months. Of this, 7 million square feet will be in the residential space. It enjoys good rental income, which, it expects to increase from its current level of Rs 1 30 crore to Rs 200 crore by 2016-17, once its new projects become operational.

The company's strategy is to maintain a land bank with five years of development potential. Over the long term, it will focus 80 per cent on residential, 10 per cent on the commercial, and 10 per cent on the hospitality segment.

Realty consumer sentiment weak in metros

- ZyFin Research publishes a Real Estate Sentiment Index every month based on Indian consumers' responses to a query on whether they plan to buy a home within the next 12 months.

- Its index has shown a slight pickup in the desire to buy a home between August 2013 and January 2014.

- But this index is the average of 80 cities. We need to dig deeper.

- In the major metros, there has been a decline in the desire to buy.

- In tier II cities, on the other hand, there has been an improvement in buying sentiment.

- In the larger cities, where people depend on service sector jobs, consumers are not confident about job security and are hence delaying big-ticket purchases like cars and homes.

- High inflation and high borrowing costs have also dented demand.

- In tier II cities, the scenario is different. The monsoon was very good in 2013. As economic activity in these cities is linked to agriculture and allied sectors, there has been a rise in the propensity to spend.

- Also, a rise in food prices tends to be positive for those allied to agriculture.

- Zyfin's surveys show that demand for housing will not improve until home loan rates decline.

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